Tricks of the Traders

Loans and securities are not merely products. While progressive forces can win some political battles by deploying the product metaphor, it obscures more than it illuminates. Consider the practice of “high-frequency trading.”

Not only are the markets completely computerized, more than half of the market’s volume is churned by computers programmed to spot certain patterns in trading. These machines see stocks not as securities used by companies to raise money, but rather, symbols, numbers and bits that are traded, swapped and exchanged.

And now, traders say, humans are responding to machines rather than the other way around. Increasingly, too, the machines are reacting to each other, trying to second-guess what their next moves might be on how to take advantage of an edge that might be gone in milliseconds.

As Keynes might have predicted, we have “reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.” The machines are perhaps devoted to “practice the fourth, fifth and higher degrees.” But there’s a twist: part of the investment game now appears to be a falsification of (or at least fake-outs via) data on such opinions:

Rapid-fire computer systems allow sophisticated traders, including the giant Wall Street firms, to post bid (buy) and offer (sell) prices they have no intention of actually following through on . . . . For instance, a firm might post a bid for a stock showing they want to buy at a certain price. But by the time investors interested in selling at that price get their order to the market, the false buyer yanks the electronic bid literally faster than a blink of the eye . . . This interplay happens in milliseconds, making it difficult to detect. . . . [T]he firms that are physically located nearest the market centers in New York and pay market-access fees get a leg up.

One physical barrier to equality here is mere location: “Each 186 miles a trader is physically located away from the New York trading center, about a millisecond is added to the time to execute a trade.” There’s no way to discern “honest signals” in such an accelerated environment. Other tricks include effectively spamming the market:

Thanks to low-cost and automated trading, trading firms can swamp markets with a deluge of buy and sell orders in a way that gives them an advantage . . . As other firms must parse through the extraneous trades, slowing them down, the firms behind the pseudo bids and offers can ignore them, saving them milliseconds of analysis time. This gives their computers valuable extra milliseconds to parse true trends in the market and gain an advantage, [Eric Hunsader, founder of market data feed provider Nanex] says . . . [A]nyone who knows some of those trades can be ignored gets a huge advantage.

The destructive potential of these dynamics is clear. John Jacobs, the COO of LimeBrokerage, told the SEC in 2009 that “unrestrained computer-generated trading has the potential to create catastrophic economic damage to the U.S. national market system.”

Rather than reflecting or reporting or trading on changes in the value of a given security, the HFTers appear to be creating such changes. On the most charitable reading, they are “engines, not cameras,” like the now-discredited theories of finance that led to their rise. On a less-charitable view, they should be the subject of agnotology, the science of “how and why various forms of knowing do not come to be.” Doubt is their product, or at the very least the condition under which they thrive. As Senator Kaufman said in a hearing:

No one at the SEC as far as I know, or anyone else really, knows what actually goes in the market centers that are engaged in high-frequency trading. And now with high-frequency tradings at between 60 percent and 70 percent of all market transactions, sometimes things get too big to fail, sometimes things get too big to even look into.

Some hope that “radical transparency” and better reporting standards will improve matters. I’m beginning to think we have little to rely on other than a cultural turn toward investing in projects with real social value. Rather than viewing investment as a zero-sum game of predicting the valuation of securities as products, we might begin to think of it as a process of supporting certain futures over others. Flash trading and other forms of short-termism merely abdicate that responsibility. They promise fast profits for those with the best computers, quants, and communications, but little hope for efficient, just, or rational capital allocation.

Share

Frank Pasquale

Frank is Professor of Law at the University of Maryland. His research agenda focuses on challenges posed to information law by rapidly changing technology, particularly in the health care, internet, and finance industries.

Frank accepts comments via email, at pasqresearch@gmail.com. All comments emailed to pasqresearch@gmail.com may be posted here (in whole or in part), with or without attribution, either as "Dissents of the Day" or as parts of follow-up post(s). Please indicate in your comment whether or not you would like attribution, or would prefer your comment (if it is selected for posting) to be anonymous.